Economic Moats – Consumers Worst Enemy, Investors Best Friend?

“In business, I look for economic castles protected by unbreachable ‘moats’.” – Warren Buffett

The best kinds of businesses that I love are the ones with strong economic moats. They are often characterized by supernormal profits and high returns on capital. In this post, I characterize the different economic moats that exist.

Companies with profitable margins are often eroded over time. The bubble tea craze a few year back is a textbook case. Initial start-ups were immensely profitable and its novelty soon became a craze. Competitors soon entered the market and before long, the once profitable industry became over-saturated and profits plummeted.The bubble tea industry is one in which firms possess virtually no economic moat at all. Coupled with the fact that entering the industry was relatively low, pioneers of bubble tea were soon unable to maintain past profit margins.

Industry Without an Economic Moat

You will often find firms with economic moats to be extremely profitable in the long run – provided that their competitive advantage is maintained.

Type of Moat Examples
Intangible Assets Tiffanys & Company, Nike, Coke
Customer Switching Costs Adobe. Microsoft
Network Effect Microsoft, Visa, eBay
Cost Advantages Dell

 

Intangible Assets – Brands, patent and regulatory licences. Patents of drugs drives profits from pharmaceutical companies – one reason why they are so highly guarded. Strong brand names such as Nike or Tiffanys & Co. allow companies to charge much higher premiums as compared to their competitors. If consumers are willing to pay a premium for a brand name – you have evidence of a moat.

Customer Switching Costs – Adobe has come to become the gold standard for image editing software.  Most designing firms run using its propriety software not because it’ cheap but because were trained using Adobe Photoshop. Switching to cheaper software doesn’t make sense as any savings made will most likely be offset by the loss of productivity (not to mention the risk involved).

Network Effect- Credit card companies are a prime example of this economic moat. You’ll find that shops readily accept cards like AMEX or VISA. Competitors who try to enter the market will be hard pressed to competing against well established networks.

Cost Advantages – Dell, famous for their optimizing and reducing cost in the process flow has done exceedingly well compared to its competitors. By cutting out the middle-man and selling directly to consumers, they have a comparative advantage against well established players like HP.

This list is by no means exhaustive but merely acts as a good reference point.

I recommend reading “The Five Rules for Successful Stock Investing” as a great primer for learning more about economic moats in different industries.  I also recommend “The Little Book That Builds Wealth” as a secondary reading.

I will be covering economic moats of locally listed companies in my next post. Look out for it!

Starhub – Irrational Debt Levels; Irrational Management?

There has been much speculation & confusion regarding the significant amounts of debt that Starhub now carries on its balance sheets. As of September 2010, Starhub possessed an astounding financial leverage ratio of 33.8. This means that for every dollar in equity, the firm had $33.8 in assets (anything above 4 or 5 is a potential red flag.)

So what’s going on here?

Bank loans made up 0.9 billion dollars in 2009! Let us take a closer look at the footnotes.

Even in a world awash with cheap money, I found the interest rate that Starhub was borrowing at to be extremely low. In 2009, their floating rate loans bore i/r of only 1.24% to 2.13%. This already low interest rate was reduced further in 2009 to only 0.92% to 1.39%. In opinion, it makes perfect sense for Management to leverage on the historically low rates to fund their capital expenditures.

Healthy Cash Flow Levels in Starhub:

Starhub is one of the few companies that use Free Cash Flow figures in their annual reports (a plus point for me) and for good reason. Even in the wake of the financial recession, they have posted impressive results.  I do not foresee a problem with loan repayments at this current point of time.

The Bear Case:

Starhub paid $20 Million in interest from bank loans last year (taken from the Cash Flow Statement of 2009’s Annual Report). Assuming that interest rates suddenly quadruple (highly unlikely in the near future but let’s take the worst case scenario here) to 5.6%, Starhub would have to fork out $80 Million in interest payments. A sizeable increase of $60 Million – but still within tolerable limits. I envision that as long as interest rates remain at their current levels, Starhub will have no qualms about maintaining the status quo.

 

Cash Flow Statement from Starhub Third Quarter 2010.

I want to bring your attention to another point – Refinancing. Judging from their cash flow statements, I suspect that Starhub is refinancing significant portions of their debt as the maturity date loans. This is akin to what REITs do when their debt is about to expire. In other words, they will be able to extend their loan maturity dates as long as they remain credit worthy.

I came across a post in another blog stating that Starhub was not making enough in FCF to cover their monthly 5.0cents dividend payment. The more risk adverse among you (it could be just me though..) might be wondering why Starhub doesn’t reduce its dividend payment in order to give itself a greater buffer or margin of safety. The argument is that once a company has started paying a regular dividend (in this case Starhub has committed itself to 5.0cents a quarter), the market will expect it continue the cycle at regular intervals forever. Any disruption to this cycle will be perceived as a potential sign of financial difficulties and a loss of confidence.

Conclusion:

In my opinion, debt levels while significant, should not pose much problem for Starhub. Close monitoring of their financial performance in their years to come is in order however. I feel that management has delivered solid returns up till this point of time and I see no reason why they wont in the years to come.

Tell-Tale Signs That Investors Should Look Out For in Reconsidering Their Investment in Starhub:

  1. Significant drops in Free Cash Flow over a sustained period (i.e. 1 – 3 years)
  2. Starhub being forced to raise additional amounts of money (i.e. through bond issues) AND refusing to cut its dividend yield
  3. Starhub taking on even more debt despite a significant rise in interest rates.

When faced with special situations such as these, its always good to dig deeper into the financial statements. Always make sure you understand the debt structure of the company. If its too complex, skip it. There are plenty of other companies that are much easier to understand.

Disclaimer: The author is vested in Starhub.